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How Equity Dilution Impacts Investors

Equity dilution occurs when a company issues new shares of stock to investors, decreasing the ownership percentage of existing shareholders.

What You’ll Read 

  • What is equity dilution?
  • How equity dilution impacts investors 
  • Factors impacting equity dilution
  • How much dilution to expect
  • How to protect your ownership percentage
  • Why dilution is common for startups 

Key Takeaways

  • Equity dilution occurs when an investor’s ownership percentage decreases as additional shares are issued.
  • Dilution may happen during multiple rounds of fundraising.
  • There are several factors that impact equity dilution, including stock issuances. 
  • Investors can protect against possible dilution by negotiating pro rata rights with the company. 
  • Not all dilution is bad. Sometimes dilution is a necessary outcome for companies that need outside capital to grow. 

Let’s say, as an early-stage investor, you purchase 1,000,000 shares of Company A for $1 each in the company’s Series A fundraising round. After your investment, there are 10,000,000 shares outstanding, which makes your $1M investment worth 10% of the company’s $10M post-money valuation. 

Over time, Company A raises more capital from new investors in their Series B and Series C fundraising rounds. 

One day, an acquirer enters the picture and buys Company A for $100M.

You’re expecting 10% of the sale proceeds to hit your bank account for a $10M payday, but you come to realize that you're only entitled to $5M.

What happened between the time you made the investment and the acquisition?

Below, we’ll discuss everything you need to know about equity dilution.

What is Equity Dilution? 

Equity dilution— also known as “share dilution” or “fundraising dilution”— is when existing shareholders’ ownership percentage is reduced as a result of the company issuing new securities to investors. 

This occurrence is particularly common for startup companies and private market investors. 

When an entrepreneur starts a company, they typically own all outstanding shares. If they were to sell the company to someone else, they’d retain 100% of the net sale proceeds. 

However, during the fundraising process, startups issue securities in exchange for capital from investors. When the transaction is made, investors typically receive a fixed number of shares (equity) or a promise of future shares (SAFEs or convertible notes) for their investment. Importantly, this does not mean investors retain a fixed percentage ownership in the company. 

As a company raises additional capital from investors, each existing investor’s shares will represent a smaller percentage of the overall company. This is because the total number of outstanding shares increases, but existing shareholders own the same number of shares. 

Dilution starts from the first moment an entrepreneur raises outside capital either in the form of a SAFE, convertible note, or equity. This occurs whether or not the investor receives the shares at that moment or is given a promise to receive shares in the future. Even if the entrepreneur is giving investors a promise for future equity, the entrepreneur must consider future share conversions in order to forecast how much of the company investors will own in the future.  

How Equity Dilution Impacts Investors 

Share dilution often impacts startup investors, especially considering high-growth companies need capital to fund their operations.  

Back to our example above, let’s say you’re the first venture capital investor in a company. You purchase 1,000,000 shares in the company’s Series A round for $1M on a $10M post-money valuation. Your 1,000,000 shares are worth 10% of the value of the company.  

Years later, the company needs more capital to grow, so it issues 5,000,000 more shares to new investors in its Series B fundraising round. 

And again, a few years later the company issued another 5,000,000 shares to investors in its Series C fundraising round. 

At this point, there are 20,000,000 total outstanding shares, and since you still own 1,000,000 shares, your ownership stake has been reduced from 10% to 5%.

As you can see, investors can be directly impacted by dilution, as more shares are issued, reducing your effective ownership in the company. If there was a liquidity event, you would be entitled to 5% of the proceeds, instead of the original 10% ownership you had.

Factors Impacting Equity Dilution 

Think shares of stock are the only thing that determines the amount of dilution investors can expect? Not so fast.

When investors purchase securities in a company, they want to know how many other shares or convertible securities are outstanding to understand how their investment may be diluted in the future. At the earliest stages of investment, for example, a pre-seed or seed round, investors will want to understand how many other outstanding convertible securities have been issued to investors, as well as shares set aside for the employee option pool. Additionally, investors will want to know if they are purchasing a pre-money SAFE or a post-money SAFE because the difference will determine how much dilution you experience when the SAFE converts to equity. 

Remember, when an investor purchases equity in a company, the price per share they pay is the pre-money valuation divided by the fully diluted capitalization table. The larger the fully diluted capitalization table (remember: this represents all existing shares and any shares authorized to be issued in the future) is, the smaller an investor will pay per share and the more shares an investor will receive for a given investment. 

What’s included in the fully diluted capitalization table of a priced equity round? Well, this can be a point of negotiation between the entrepreneur and investors.

There are three key factors that impact the fully diluted capitalization table:

  1. Treatment of convertible securities: this includes any previously issued convertible notes or SAFEs. 
  2. Outstanding warrants and options: this includes all options and warrants outstanding prior to the investment even if the holder may never actually exercise the warrants or options. 
  3. Treatment of shares reserved in the employee option pool, as well as accounting for an increase in the employee option pool: companies often set aside option pools for their employees as a form of equity compensation. This can impact dilution once the employee exercises their options, converting them into shares of stock. Therefore, investors typically request that all shares set aside in the option pool be included in the fully diluted capitalization table, as well as account for an increase in the employee option pool for future team members. 

Whether or not the above factors are included in the fully diluted capitalization table of a financing round depends on negotiations between the investor and entrepreneur during the raise. 

How Much Dilution to Expect 

The amount of dilution that occurs during a fundraising round varies greatly depending on the type and size of the round. 

That said, you can expect the following as a general guideline:

  • 20-25% dilution during Seed funding
  • 15-25% during Series A
  • 15-20% during Series B 

Most data suggests that dilution during Series C and later funding is highly dependent on a company’s valuation and funding needs. 

How to Protect Your Equity Ownership Percentage 

One way that investors can protect their equity ownership percentage is through formal pro rata rights. 

Pro rata rights represent an agreement between an investor and the company, giving the investor the right to participate in future fundraising rounds and retain their ownership percentage. 

Importantly, investors with pro rata rights are not required to invest in a future fundraising round but reserve the optionality to participate if they choose to. 

Pro rata rights are a privilege that is not granted to all investors, but rather only reserved for select investors. These rights are typically granted to investors via a side letter if occurring during a SAFE or convertible note investment, or in transaction documentation if included in a priced equity fundraising round. Beyond the formal extension of pro rata rights, investors must show the company why they deserve pro rata rights by being particularly helpful to the entrepreneur. 

Why Dilution is Common for Startups

Equity dilution is a common occurrence that impacts many private market investors in high-growth companies.  

The reason comes down to a natural characteristic of technology companies that choose the venture capital route: startups require outside capital to grow rapidly in order to spend on product innovation, control certain markets, and beat out competition.  

With that said, not all dilution is bad. As a company takes on additional outside funding and uses the capital to increase revenue and service new customers, the overall valuation of a company can increase significantly. Ultimately, owning a smaller percentage of a high-value company can still be more lucrative than owning a larger percentage of a relatively smaller company. 

Raising outside capital can be an integral part of a company’s business model as long as it is done responsibly alongside sustainable growth rates and a path toward profitability. 

How Zest Can Help 

Zest can help founders present information and communicate transparently with their shareholders, all while streamlining their cap table. 

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time and reduce administrative costs, simplifying the end-to-end investment process.

Get started with Zest today. 

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